Non-USD Stablecoins & On-Chain FX

05 Oct, 2023

The United States dollar (USD) remains the world’s principal reserve currency and the most widely used for international trade.

The USD accounts for a 60%–albeit declining–share of foreign exchange reserves worldwide. It also accounts for around 40% of SWIFT payments and 85% of FX transaction volume.

This number, however, is grossly disproportionate to the dominance of USD-denominated stablecoins on-chain. As of the date of writing, the total market capitalization of USD stables sits around $125b, whereas the market capitalization of non-USD stables is around $425m, or about 0.34%. This places on-chain USD dominance at 99.66%. This is also true for trading volume, with over $30-40b in daily volume for USD stablecoins vs. around $5-10m for non-USD stablecoins, which places USD stablecoin dominance by trading volume at over 99.97%. In short, non-USD stablecoins are virtually nonexistent today and account for nothing more than a rounding error.

It is hard to explain the overwhelming USD dominance in crypto. As an industry, we strive to be global, accessible, and inclusive–an ethos that remains one of the main reasons why people get into crypto in the first place. This ethos, however, has so far stopped short of enabling greater accessibility through non-USD stablecoins and robust, efficient on-chain FX markets, which in turn would unlock atomic intra- and cross-border payments and remittances, macro directional trading, individual, corporate, and institutional hedging, etc.

Before trying to create our own alternative currencies – mostly a failed endeavor so far – we should focus on creating better markets and payment flows for existing currencies–that is, solving real world pain points and upgrading legacy infrastructure.

If we achieved a similar distribution to what we currently see in traditional finance, non-USD stablecoin market capitalization could easily grow to around $50b and daily trading volumes could rise to around $20b–laying the groundwork for the accessibility and inclusivity many of us are working toward. After all, this is why we Crypto.

The Role of Regulation

It is impossible to discuss stablecoins without addressing the topic of regulation. Given USD dominance, the logical step was to start here; however, the regulatory framework for stablecoins in the US remains opaque and contentious. This is evidenced by SEC enforcement actions against stablecoin issuers, including Paxos. Meanwhile, Circle, the issuer of USDC, and other leaders continue lobbying for clearer regulation. As a result of these widespread industry lobbying efforts, the House Financial Services Committee introduced a bill, which received bipartisan support. While this has been a welcome development, significant points of contention remain and the timeline for implementation is uncertain.

At the same time, several other jurisdictions have been faster to provide regularity clarity to stablecoin issuers. This includes amendments to electronic money regulations and payment service regulations in the UK to include stablecoins, as well as the introduction of the Financial Services and Markets Act 2023, which recently passed into law. Another example is the Markets in Crypto Assets (MiCa) regulation in the EU, which sets out a clear path for stablecoin issuers to become regulated. Japan has also introduced its own stablecoin regulatory framework in 2022. Singapore recently did the same. Similar efforts to regulate stablecoins are currently in motion around the world, with clearer timelines and less contentiousness compared to what we are currently observing in the US.

The US lagging behind when it comes to providing regulatory clarity on stablecoins will likely be a catalyst for the growth of non-USD stablecoins. Of course, this is still far from a worldwide phenomenon and many countries that could benefit the most from stablecoins, primarily emerging economies, have been slow to introduce appropriate regulation, but are also not actively cracking down on stablecoin issuers.

On-Chain FX Trading

Perhaps the most obvious and foundational benefit of growing non-USD stablecoin issuance and liquidity on-chain is the ability to create alternative foreign exchange (FX) markets that have the potential to offer better uptime, smaller transaction fees and atomic trade finality and settlement. Robust, on-chain FX markets can benefit a whole spectrum of use cases and end users while removing the reliance on antiquated infrastructure and various third party intermediaries (for more on this, see Circle and Uniswap’s report here).

One clear use case is the ability for FX markets to facilitate macro directional trading, as well as hedging–whether for institutional, corporate, or retail users. It is worth spending some time reviewing the current on-chain exchange protocols that could enable FX trading and comparing them with existing FX trading venues.

I’ll start with a crash course on decentralized exchanges. There are, roughly, three main designs:

• Automated Market Makers (AMMs)
• Concentrated Liquidity Market Makers (CLMMs)
• On-Chain Central Limit Order Books (CLOBs)

Automated Market Makers (AMMs)

AMMs were the first generation of exchanges that could operate fully on-chain and handle price discovery based on market dynamics. They rely on liquidity pools in which liquidity providers (“LPs”) deposit an equal value of two tokens to facilitate trading for a specific pair. The balance of each token within the pool is dictated by a bonding curve that typically follows a constant product formula (x * y = k), which can be visualized as a hyperbola:

After a swap is transacted, the relative balance of each token in the pool can be represented by a new point on the curve. The AMM then adjusts the price of the pair as this balance shifts to ensure that there will always be liquidity. The price is determined by calculating the slope of the curve at a given point (P = dy/dx).

Price impact or slippage refers to the influence of a specific trade on the price of the tokens. It is proportionate with the size of the trade relative to the amount of liquidity available in the pool. There is a minimum price impact value typically ranging around 30bps on constant-product AMMs: this is the fee charged for each trade.

The shortfalls of this design are largely associated with impermanent loss and lazy liquidity:

• Impermanent loss (“IL”) refers to the opportunity cost incurred by LPs when providing liquidity in a dual-token pool rather than simply holding both tokens. As token prices fluctuate, an LP’s share of the pool stays constant but the balance of the tokens will vary: an LP who initially provided an equal value of two tokens can end up with a different ratio of tokens if the price of one token fluctuates relative to the other. In effect, this means that LPs are sacrificing part of the potential upside from price appreciation in exchange for yield. This effect is exacerbated by LPing two volatile, uncorrelated assets together.

• Unlike a traditional order book where liquidity is aggregated into specific amounts and at specific prices based on market maker activity, AMMs offer blanket liquidity where LP contributions cover all sizes and prices.. This is what can be referred to as lazy liquidity. It makes providing liquidity much more accessible by a variety of market participants but is also a much less capital efficient approach. It does, however, also allow for the creation of composable deposit tokens or LP tokens, which represent these positions and their associated yield and can be deployed across other on-chain protocols (including the ability to use them as on-chain collateral).

Optimization of AMMs for Stableswaps

Some AMMs are specifically designed to facilitate swaps between assets that are highly correlated in price. They are generally referred to as “stableswaps”.

They combine linear bonding curves (with no slippage) and constant product bonding curves (seen in typical AMMs) to create AMMs where the pool can slide up or down the curve only when pools are pretty balanced and the price is stable around a peg price.

These stableswap AMMs, such as Platypus or Curve, can be optimal for pairing stablecoins pegged to the same underlying currency–for example, offering the ability to swap two euro-pegged stablecoins offered by different issuers. For LPs, this means no (or very low chance of) IL in addition to receiving yield bearing LP tokens, which can be further utilized on-chan (as in the example above). For stableswap end users, these AMMs can offer a variety of functional on-chain benefits, including the ability to:

• Easily convert holdings to a new or preferred stablecoin provider
• Diversify exposure beyond a single provider
• Quickly swap holdings for deployment into a particular DeFi opportunity
• Convert holdings because of infrastructure integrations (e.g., if an on/off ramp provider accepts or prefers a particular stablecoin)

Overall, stableswaps make it easier to hold and deploy stables on-chain, while providing LPs with an attractive, relatively lower risk opportunity than standard AMMs.

Concentrated Liquidity Market Makers (CLMMs)

CLMMs are hybrid constructs that combine properties of AMMs and order books, essentially creating efficient on-chain pseudo order-books.

This model was pioneered by Uniswap with the introduction of Uniswap V3 but has since been widely adopted, with competitors like Trader Joe introducing changes to the base formula. CLMMs abandon the lazy liquidity property associated with traditional AMMs in favor of better capital efficiency. As the name suggests, they concentrate liquidity in price ranges and require LPs to take a more active role when depositing and distributing liquidity. The best way to think about them, in my opinion, is to see them as order books with a very large tick size.

Oracle-Based Concentrated Liquidity Exchanges

Some exchanges abandon the ability to achieve price discovery and instead rely on oracles to concentrate liquidity around an existing, off-chain market price. They can not safely be relied on as primary sources of liquidity but can provide very competitive secondary on-chain venues for FX trading by referencing off-chain pricing. A good example of this model is Xave:

The bonding curve depicted above can be divided into two areas: it is flatter around the oracle-based price, enabling trades with very low slippage at an accurate exchange rate, and steeper when the pool is imbalanced to prevent liquidity draining. The main reason why these exchanges cannot become primary liquidity venues is because they rely on external oracles to set prices and would end up self-referencing if they became the primary liquidity and trading venue for a given stablecoin.

On-Chain Central Limit Order Books (CLOBs)

On-Chain CLOBs are, for the most part, self-explanatory. Their mechanism is identical to most centralized exchanges operating today with an order book that matches both buy and sell orders at a specific price. For a long time, they were impossible to host on-chain due to throughput and finality limitations of older blockchains. However, newer technology, such as Avalanche Subnets, enable dedicated blockchains to host these transaction intensive order books on-chain. A good example of this is Dexalot.

These exchanges, if adopted by enough market makers to create liquid markets, could rival the capital efficiency of existing off-chain FX markets. They are, however, less composable and much less accessible for retail users when it comes to providing liquidity.

Quantifying the Competitiveness of On-chain Exchanges

Particularly for retail end users and small businesses, those who typically are disadvantaged the most by wide FX spreads (see below for further details), on-chain exchanges should serve as a more competitive and compelling option than traditional solutions.

If we take the example of the EUROC token on Avalanche, which is currently trading on both Xave and Trader Joe, we can see that the price can deviate from the official exchange rate by up to 1%:

Deviations typically occur when given trade volume disproportionately surprasses available liquidity. For example, the EUROC/USDC pool on Trader Joe currently has $1.5M of total liquidity but has seen up to $2.8M in daily volume. The same pool on Xave has $610k of liquidity but has seen $790k in daily volume. You’ll notice the deviation is quickly corrected (based on the chart above). This correction is effectuated by market arbitrageurs tracking the official off-chain exchange rate and rebalancing the AMM pool to make a profit.

You can see this rebalancing in action in the chart below, which shows how the distribution of EUROC and USDC within a Xave pool changes over time, regularly going in and out of balance:

Even in the most extreme deviations, however, the spread remains substantially below that which a retail user or small business might have to pay for a comparable FX transaction off-chain and quickly compresses.

Overall, while it remains to be seen which type of exchange design will prevail, these on-chain innovations have the ability to upgrade legacy infrastructure and potentially eliminate the need for several third party intermediaries charging unnecessary fees for smaller transactions (see below for more details). In addition, in the case of AMMs, they may create novel passive income-type opportunities for a wider set of participants through the LP pool model.

Summary Advantages of On-Chain FX Trading:

• 24/7
• Less expensive especially for retail and small businesses
• More widely accessible
• Composable
• Instant transactions finality and settlement
• Less operationally intensive

Remittances & Cross-Border Payments

Creating alternative, liquid FX markets on-chain is just the foundational step in achieving a much larger vision from a global utility and payments perspective. Remittances and cross-border payments are notoriously complex and expensive, in part due to the limitations of legacy banking infrastructure and exacerbated by the high fees charged by well-established intermediaries, such as Western Union, extracting value.

In 2022, countries received more than $831b of combined remittance inflows, with over 77% of these inflows received by low and middle-income countries (see table in Appendix). India, Mexico, China, the Philippines and France were the top five countries with the most remittance inflows.

Western Union fees can be as high as 29% for smaller payments, and brokers are allowed to collect a margin of up to 6% on FX transactions for most countries (excluding the Eurozone). In comparison, swapping on FX exchanges on-chain would incur fees of around 0.01% to 0.3%, in addition to fixed transaction fees that would be in the order of a few cents per transaction. Even if you include on-ramping and off-ramping fees, which range between 1.5% and 4% in most cases, as well as the aforementioned price deviations, remittances on-chain remain competitive.

I’m all too familiar with this myself. My own country, Lebanon, is the world’s most remittance-dependent country, with remittances accounting for over 50% of the country’s GDP. Sending money in and out of the country is a real struggle: the lucky few rely on foreign bank accounts, but most people need to either go through (dysfunctional) Lebanese banks or intermediaries such as Western Union, where they incur predatory, inaccurate exchange rates and eye-watering fees.

There is a real, tangible, opportunity here: the current on-chain infrastructure is already much more efficient, cheaper and more transparent than traditional remittance payment rails in most developing economies.

Derivatives

In addition to spot transactions, robust on-chain FX markets would also promote the creation of derivatives markets for macro directional trading and hedging purposes.

Protocols such as Hubble and GMX can be used to create perpetual futures that track the price of underlying currencies and enable leveraged trading strategies. Protocol profits from trading and market making can be redistributed to liquidity providers, creating additional opportunities to earn yield on on-chain currency deposits (as previously mentioned).

And while on-chain options protocols remain relatively nascent, they can become powerful tools for hedging exposure to various currencies. There are many different protocols that have the potential to enable this, ranging from fully on-chain models (e.g., Panoptic, Kibo) to hybrids that rely on off-chain market makers and order books (e.g., Volare, Aevo).

A large reason why on-chain options protocols (and, to an extent, perpetual futures exchanges) are still limited in liquidity is their sole focus on crypto assets. Introducing derivatives for various well-adopted non-USD stablecoins could be instrumental in spearheading the growth and adoption of these protocols by attracting exponentially higher amounts of liquidity.

In the shorter term, synthetic currency derivatives can allow users to trade and get price exposure to smaller local currencies. A good example here would be Baki, a protocol that aims to create synthetic FX markets for various African currencies.

There is still considerable work to be done across these different areas, but it is clear to me that on-chain protocols have the potential to replace traditional currency derivatives markets.

Creating Liquid Markets for Historically Illiquid Currencies

This last use case might sound a little far fetched but could be one of the most immediately useful examples justifying the opportunity for non-USD stablecoins.

Think of Argentina, Lebanon, Syria or Ethiopia. They have one thing in common: their reliance on black markets for trading and pricing local currencies. In some of these cases, this is exacerbated by capital controls imposed on banks and restrictions on currency outflows.

This generally means that these local currencies are trading with very fragmented liquidity without a unified price. Each broker will quote slightly different prices, with limited liquidity; there is no common trading venue. This means that spreads are generally extremely wide to account for uncertainty and high volatility. It also means that currency prices are very easily manipulated.

Locals generally rely on websites and apps that will attempt to track the parallel black market rates, relying on brokers and users declaring their recent trades:

This can be solved by tokenizing the local currency and listing it on an on-chain exchange. On-chain exchanges can provide a more accurate, transparent alternative rate for these currencies, while also reducing liquidity fragmentation. Of course, this would require existing participants in those black markets to adopt a given on-chain exchange as their primary source of truth. Each individual broker could act as an on-ramp and off-ramp for the stablecoin, where locals would be able to deposit or withdraw their local currency.

Such an initiative would certainly require a certain level of collaboration and oversight, but has obvious benefits: locals would now be able to trade their local currency remotely, at better rates, and reduce their reliance on cash. They could receive USD-denominated stablecoins in return, which they can then either off-ramp through existing peer-to-peer networks or hold on-chain and transfer at extremely competitive fees.

Key Takeaways

I hope that this piece sheds some light on the benefits of creating non-USD stablecoins and improving their on-chain adoption and liquidity. This is far from a comprehensive overview of all possible use cases that could arise from this effort, but it does cover the ones I believe are the most immediately useful and achievable. I can summarize my thinking as follows:

• We often assume that there is no demand for non-USD stablecoins and that the USD is the currency which we should focus on. This is not true in traditional finance: demand exists, and so this is a worthwhile effort.
• The current state of stablecoin regulation makes this opportunity even clearer: many jurisdictions are friendlier and less opaque than the US when it comes to stablecoin issuance and regulatory frameworks.
• On-chain exchanges are already developed enough to provide competitive venues for FX trading, with instant settlement, low fees, better pricing and 24/7 markets.
• Improving the availability and liquidity of non-USD stablecoins on-chain is the first step in addressing the real-world problems of remittances and cross-border payments. These markets are currently larger than the entire crypto space several times over.
• Institutional adoption can follow retail adoption: there are exchanges that perfectly mimic traditional exchanges, and various protocols that can provide markets for on-chain currency derivatives, which can be used for speculation or hedging.
• The opportunity is the most obvious in emerging economies, which often lack necessary banking infrastructure and are subject to inefficient and predatory FX markets for cross-border payments, remittances and trading of their local currencies.

Appendix

Special thanks to Morgan Krupetsky for all her feedback & edits <3

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